Minimum Wage

Some people seem convinced that increasing the minimum wage will increase GDP and not cause an increase in unemployment. It does not take much effort to think through the consequences of a minimum wage increase. Many who favor this view may be spurred on by studies that purport to show that moderate increases in the minimum wage resulted in increasing employment instead of dis-employment.

To explain the results that contradict common sense, the myth developed that increasing the minimum wage increased workers incomes. This increased income increased demand for the output these workers produced. Increased demand for these goods required increased labor for production. Thus an increase in the minimum wage leads to lower unemployment, not higher.

The errors in this thinking are very subtle. Missing from the equation is how the minimum wage is paid. Business owners, knowing that they need more revenue in order to pay their existing work force must increase prices. Increasing prices results in a lower quantity demanded for the goods. To produce less output, business owners need fewer workers and so some will be let go.

How can studies show that employment increases? The simple answer is that you have to look at the methodology. One technique used is called a difference in differences analysis. This was the technique used in Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania (American Economic Review 84 (4): 772–793).

n this study Card & Krueger looked at the effect of a minimum wage increase in New Jersey by comparing the difference in employment in restaurants before and after the minimum wage was imposed in New Jersey with the change in employment at restaurants in near by Pennsylvania. What they found was the employment in New Jersey at restaurants increased compared to the restaurants in Pennsylvania.

The flaw in this methodology is that in order to take the difference before and after the change in the minimum wage, you have to have data from a restaurant before and after. What happened is that the minimum wage caused restaurants in New Jersey to close, and their best employees went to work at the remaining restaurants. Decreased competition meant that the remaining restaurants got increases in the demand for their output so they could afford to hire additional help. This means that overall employment went down but the difference in differences analysis showed an increase.

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